Bad time to launch a career on TikTok?
September 18, 2020 by The Q.ai Team
The educational portion of this newsletter focuses on portfolio diversification
Jumping into the weekend like
If we could describe markets this week in one word, the first that comes to mind is “tumultuous.” How tumultuous? Think about Ronnie and Sammi’s relationship throughout Jersey Shore. September is a volatile month. Can’t say this enough.
This Week’s Biggest Headlines
- TikTok gets a new American fam. Oracle has been selected to oversee U.S. operations of TikTok. ByteDance will still retain majority ownership of the social media company and will likely file an IPO in the U.S. next year. The deal has unique terms. Part of the agreement is installing a board of directors – all of whom will need to be approved by the U.S. government – that includes an independent security director with national security credentials and voting power. This deal still needs to be approved by both the U.S. and Chinese government, but at this time the likelihood of it going through looks promising. Read more.
- Additionally, the U.S. has announced this morning that it will be banning TikTok on Sunday. This will limit users who have already downloaded the app from installing updates and app improvements. It is also banning WeChat, another Chinese-owned app, but with a different set of restrictions. This is a developing story – more info is expected later today. Read more.
- Let it snow IPO money, or whatever
. On Wednesday, Snowflake set the record for the largest IPO ever. The company raised $4 billion in capital before going public with its stock being priced initially at $120 per share. When the stock began trading, the price jumped to $245. At the end of trading, Snowflake was worth $70.4 billion, which is over 5x its valuation in February. Pretty cool for a company many outside the tech sector have likely never heard of prior to it going public. Read more.
- Another Fed announcement. We talk about the Federal Reserve a lot, and while it’s a total bore-fest, many of the recent updates have been truly newsworthy. On Wednesday, Fed chairman Jerome Powell announced that interest rates (which have been brought down to near-zero) are expected to stay that way until at least 2023. As a reminder, this is a strategy to help boost the labor market while tolerating slightly higher levels of inflation. The goal is to lower unemployment and revive the U.S. economy. Read more.
- Less unemployment ≠ more job openings. Initial claims are down to 860,000 but the total number of unemployed Americans is 12.6 million. On the bright side, the data trends tell us that less people are losing their jobs every week. However, those who have already lost their jobs due to the pandemic are having difficulty finding new jobs. Things are looking up, but not at the rate we all hoped for. Read more.
How to diversify my portfolio to maximize
The purpose of portfolio diversification is to minimize risk while maximizing reward across your portfolio. There are many ways to diversify a portfolio, such as by asset class or stock type. To diversify, you should spread your capital among securities that move in opposite directions, rather than all together, in order to avoid portfolio-wide losses. Furthermore, you should consider your risk-reward relationship. There is no one perfect mix for a portfolio, as every situation is different, but there are few steps investors can take to determine their best mix, including rebalancing your portfolio on market trends and adding more stocks for longer time horizons.
*Not* the definition of the word diversity, in any context.
Portfolio diversification is an investment strategy that works to manage risk while capitalizing on gains. Instead of pursuing only aggressive growth (high risk) or decades of incremental gains (low risk), diversified portfolios mix investments to produce a happy medium.
A diversified portfolio doesn’t just seek different companies in the stock market, but different types of investments as well. Several studies have shown that on average, well-diversified portfolios generate more reliable returns than non-diversified portfolios over a period of 25 years or more.
It doesn’t matter how you diversify – the goal is always the same: to minimize risk and maximize performance across investments.
Take our example investor, Investimus Prime. He’s new to stonks and decides that his first big leap is to throw half of his money into shares from a single blue chip company, AwesomeTech United. The company’s stock climbs over the course of a year – everything’s looking good!
But then, a very nondescript and completely fictional germ spreads across the globe. Markets panic. Bonds crash. Stocks drop off a cliff. And Investimus Prime’s favorite pick, AwesomeTech United, plunges 20% overnight. In one fell swoop, he has lost 10% of his portfolio’s net worth – which means he’ll need to make up more than 10% of his losses to break even.
Investimus Prime could have avoided this unfortunate incident if he had spread his money across multiple stocks. Better yet, he could have achieved a better mix by investing in a variety of asset classes with minimal correlations (i.e. when a pair of stocks don’t rise and fall in unison) to achieve a better mix.
Negative correlation is a good thing because if one stock loses value, it does not guarantee the other stock would experience the same decline. While his portfolio still would have taken a hit, it likely would have suffered less overall.
Types of Diversification
There are several ways to diversify your portfolio, and no right way is inherently right or wrong. These are the most common, “concrete” diversification tactics.
By Asset Class
When people talk diversification, one of the first things that springs to mind is not putting all of your money in stocks. While diversification is actually a lot more complex than that, diversifying across asset classes is a really good place to start.
In investing, the main asset classes include:
- Cash and equivalent: Treasury Bills, CDs, money market securities, etc.
- Stocks (equities): shares purchased from a publicly traded company
- Bonds: fixed-income securities (IOUs)
- ETFs: a “basket” of securities from a specific index, sector, etc.
- Real estate: buildings, land, water and mineral deposits, agriculture, and livestock
- Commodities: goods that produce other goods or services
Depending on which asset classes an investor chooses, they may have more or less ways to split their investments further.
By Stock or Bond Type
Investors who focus on stocks may to split investments 50/50: half in dividend-paying stocks, half in aggressive growth stocks. Alternatively, a different investor may select to invest 50% of their stock portfolio in blue chip companies, with the other half reserved for startups.
Investors who put money into bonds have a vast array of options, as well. In addition to choosing bonds by issuer (company versus federal government, etc.), it’s possible to choose bonds by whether they pay interest or have other mitigating factors.
For example, a bond investor can choose to put their money into:
- U.S. Treasury bonds
- TIPS (Treasury bonds that pay interest and adjust for inflation)
- State and municipal bonds
- Investment-grade corporate bonds
- High- or low-yield corporate bonds
Another way to diversify a portfolio is to spread investments across several sectors. For instance, some investors like to rely heavily on the aggressive growth of the technology industry to bolster their profits. However, this industry can be incredibly volatile, so moving some capital into other industries, such as manufacturing or healthcare, could be a wise decision.
One of the benefits of diversifying across sectors is that this can be done with almost any type of investment. Those who prefer stocks can select from any publicly traded company that offers stocks; those who like bonds can purchase bonds from any company that issues bonds, etc. Sector diversification is even possible in real estate, where investors can choose the type of real estate they prefer – housing, healthcare facilities, factories, etc.
By Market Capitalization
Market capitalization, or market cap, is how much a company is worth in terms of outstanding stocks. In other words, market cap is how much the company would have to pay in order to purchase all of its stock back from its shareholders.
Investors who diversify according to market cap have three basic “types” to choose from:
- Small cap companies, generally defined as a market cap between $300 million and $2 billion
- Midcap companies, generally defined as a market cap between $2 billion and $10 billion
- Large cap companies (also called big cap), generally defined as a market cap above $10 billion
While each market cap comes with its own potential risks, a well-diversified portfolio will take advantage of all the benefits from each to offset these risks.
Diversification by Correlation and Risk
There’s going to be math involved. While the above factors are good to keep in mind, at the end of the day diversifying across asset classes and market caps means nothing if you don’t account for correlation and risk in your portfolio.
Correlation Between Securities
Let’s bring Investimus Prime back for another example. He’s learned from his previous mistake and has reduced his stake in AwesomeTech United to 5% of his portfolio. He has also invested another 5% into an established technology company: Macrosoft Inc. Over time, he notices that every time AwesomeTech’s stock increases, so does Macrosoft; and when Macrosoft goes down, AwesomeTech goes down with it.
This is called a positive linear relationship, simply termed correlation. This financial metric is measured from -1 to +1. Any security pair that falls within this range is said to have a normalized correlation, be it positive or negative.
TFW you realize we weren’t joking when we said there’s math involved
If AwesomeTech and Macrosoft have a positive correlation of 0.9, there is a strong correlation between the two stocks. Therefore, when one stock moves in the market, we can expect the other to follow suit most of the time. This correlation means that buying both securities, even in different amounts, introduces a similar type of risk into your portfolio.
In other words, the stocks are going to move the same way at the same time so it’s could result twice as many losses (technically, it could also result in huge gains but let’s not focus on that
The essential risk-reward ratio compares the dollar amount earned against the risk of the investment.
For instance, if Investimus Prime calculates his risk-reward ratio for AwesomeTech United as 1:10, that means he is risking $1 for the chance to earn $10 in return.
On the other hand, if Investimus Prime discovers that his risk-reward ratio actually comes out to 10:1, that means that he is risking $10 in order to earn $1 in return.
Risk-reward relationships are frequently used when it comes to investing in the stock market, as it’s relatively easy (mathematically) to measure the risk-reward relationship of a single security. Ideally, an investor should seek to have a risk-reward ratio above 1.0 per security, which means that every investment has a greater chance of producing rewards than losing capital.
However, it’s also important to keep in mind that your overall portfolio return can override an individual risk, or even risk as a whole, when correctly diversified.
Note: we focused on return against risk as a way to measure risk-reward, but there are other ways to calculate this metric.
What Is the Perfect Mix?
There is no perfect, one-size-fits-all mix of investments for every portfolio. There are dozens of factors to account for, such as financial risk tolerance, emotional risk tolerance, current market performance, etc. This means that every individual will have to decide what the best diversification strategy and mix is for themselves (or with the help of a trusted financial advisor).
Here are a few tips to keep in mind when looking to diversify your portfolio.
- Look to the 5/25 rule. This states an investor should invest in no more than 5 asset classes at once and allocate no more than 25% of the whole portfolio to any one asset class.
- Consider mutual funds, ETFs, and asset allocation funds. You’ll gain partial ownership in several different securities at once, which reduces your risk from the get-go and lets you take part in a fund that is managed for you
- Customize your portfolio with individual securities. This is especially useful advice if you primarily invest in ETFs and mutual funds. By sprinkling in a few single securities, you diversify your portfolio further and experiment with your risk-reward ratio.
- Be patient and play the long game. The longer your investment horizon, the more portfolio room you should dedicate to non-correlated stocks. It’s important to keep in mind your age and risk tolerance when investing in any security, but if you have a particularly long-term time horizon (more than 20 years), investing more in stocks will lead to higher yields over time.
- Rebalance your portfolio regularly. Whether you hire an advisor or invest on your own, it’s important to make sure that every few months you scrutinize your portfolio and remove securities that chronically underperform or carry too high of a risk. This also gives you a chance to invest in new securities without throwing in a bunch of fresh capital.
The Bottom Line?
Portfolio diversification is intended to lead to lower risk and better results. There are several ways to diversify, such as by asset class, sector, market capitalization, and correlation. Usually, investors select a mix of alternatives to diversify their portfolio to the fullest extent. Don’t get too focused on upping your returns, though. It can raise risks you weren’t aware were there.
Everyone has to start somewhere. And this (very short) essay details why it’s not such a bad thing to be a “noob.” To be a noob means you’re in the state of learning – of growth. Many of you are brand new to investing, and while intimidating at first, it’s an amazing step in the right direction. Why? You’re taking control over your financial future. If there’s anything we can all agree on, it’s that having savings gives you more choice. That’s powerful.